FX traders are a confused lot right now. In the age of Donald Trump, Brexit, China, protectionism and populism, it is becoming increasingly challenging to predict where any of the financial markets are headed.
Last year, rising US interest rates and a hawkish Fed helped drive the dollar higher. Now, both interest rates and the Fed have changed course. Yet the dollar index is trading today near its highs of the year.
In times like this, my approach to understanding the markets is to remove myself from the high frequency noise, take a big step back, and attempt to determine which of the big themes will drive or dominate markets over my time frame. There are plenty to choose from. Then I determine what impact these may have on the dollar.
Here are my five themes that matter to FX markets in 2019
1. The US-China trade war
US mercantilism. President Trump sees global trade as a zero-sum game in which the country with the biggest surplus wins. This type of economic policy is known as mercantilism, where governments seek to ensure that exports exceed imports in order to accumulate greater wealth and power – in effect, economic nationalism.
Chinese mercantilism. China practices its own version of mercantilism and does so on an unparalleled scale, using an extensive assortment of policies to assist Chinese firms while discriminating against foreign firms trying to compete in China.
The USD/CNY. The current geopolitical and technological rivalry between the two countries is a long-term game, and animosity will build over time. Therefore, any trade truce should have a limited life. With so much global trade at risk, the Chinese yuan has become THE currency to watch versus the dollar. The yuan’s strength or weakness is becoming increasingly accurate as a prelude to movements in other currencies.
2. Soft US interest rates
Fed’s pivot fuels “risk-on” rally. In January, our hawkish Fed suddenly became a dove. “It’s about as drastic a reversal as a central bank could possibly pull off within six weeks,” said John Authers on Bloomberg.com. Risky equities and emerging market assets have been primary beneficiaries.
Fed eyes other factors. Fed Chair Jerome Powell noted that besides being “data-dependent”, the Fed has its eye on other factors, including slowing growth in Europe and China, and the US Government shutdown.
US yield curve. Analysts are closely monitoring the shape of the US yield curve, which has been flattening and now approaches inversion; historically, this is a prelude to recession. Our view is that it will likely invert in H2, as long-term US Treasury yields are forced down by disinflationary demographics and demand for safe assets, while short-term rates, which are tied to the Fed’s rate, are on hold.
The US dollar may weaken if the Fed does not raise rates at its March meeting, and if US long-term yields continue to slide.
3. Global economic growth in decline
The International Monetary Fund recently warned us that the global economy is slowing faster than expected due to weakening market sentiment, trade policy uncertainty, and concerns about China’s economic outlook.
- China’s economy is slowing, so the Chinese are planning massive reflation policies, but these may not kick in until 2020.
- Germany, with the highest trade surplus in the world, narrowly avoided a recession in the fourth quarter.
- US economic performance is still strong and corporate profits high, but our economy will eventually enter its “late-cycle”, typically characterized by slow growth, rising inflation, a tightening Fed and a flattening yield curve. Many economists forecast a recession late 2019 or 2020.
The dollar should weaken as our economy slows, as European economies pull out of the trough of their economic cycles, and as China’s reflation policies take hold. One big caveat: if China’s economy slows too much, the PBOC may resort to depreciating the renminbi, inciting further trade conflict.
4. Brexit uncertainty
Brexit could be the biggest story for the global economy in 2019.
The UK is scheduled to leave the EU on March 29, 2019; however, its exit terms are still uncertain. The 2016 Brexit vote has already been an impediment to UK economic growth. If the UK crashes out of the EU with no deal, further economic decline could be felt for years to come.
The UK pound would suffer accordingly.
5. European parliamentary elections
Elections for the European Parliament will be held on May 23-26. “They may likely change the face of Europe more than anything that has been done since the EU was founded,” says Raul Meijer, Editor of French The Automatic Earth blog.
Many EU countries – France, Germany, Spain, Austria, and Italy – have held general elections with outcomes that were unexpected or which shook up the status quo. Overall, the centrist pro-EU majority will likely hold, but populists and nationalists are set to make big gains, with immigration as the top issue for most countries.
The euro will weaken on the outcome.
This is not the time to think long term – there are simply too many unknowns.The dollar may remain firm over the coming few months, as the global economy slows, risky assets are driven lower, and the dollar serves as a safe haven.
Later in the year, we expect the dollar to weaken with a dovish Fed, lower US rates, and a slowing US economy.
All this, along with relatively overvalued US equities, will urge Global investors to move out of US assets, leading to a lower dollar.
Patience is the watchword.
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